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What is a 'Vertical Merger'

A vertical merger is a merger between two companies that operate at separate stages of the production process for a specific finished product. A vertical merger occurs when two or more firms, operating at different levels within an industry's supply chain, merge operations. Most often, the logic behind the merger is to increase synergies created by merging firms that would be more efficient operating as one.

BREAKING DOWN 'Vertical Merger'

A vertical merger, also known as a vertical integration, is a merger between a manufacturer and a supplier within the same industry. These types of mergers or integrations occur when a company seeks to reduce operating costs and increase efficiency to realize higher profits. Combining the operations of two companies allows a parent company to control the entire production cycle of a product by incorporating two businesses as a single business entity.

An example of a vertical merger is a car manufacturer purchasing a tire company. Such a vertical merger reduces the cost of tires for the automaker and potentially expands its business by allowing it to supply tires to competing automakers. This example shows how a vertical merger can be twice as beneficial to the company conducting the integration. The initial benefit is the reduction in supplier costs that leads to an increase in profitability. The second benefit is an expansion in revenue streams that also increases the bottom line.

Types of Vertical Mergers

The typical supply chain of an industry consists of five steps: raw materials, intermediate manufacturing, assembly, distribution and the end customer. There are two types of vertical merger strategies, backward integration and forward integration, that move vertically up or down the supply chain to achieve a vertical integration.

A backward integration normally occurs when a manufacturer moves up the supply chain to own the supplier of its raw materials. For example, an intermediate manufacturer that wants to reduce the costs of production can merge or acquire a supplier of materials. If a tire manufacturer integrates with one of its rubber suppliers, it realizes lower operating costs and higher profit margins.

A forward integration happens when a company within the supply chain moves down to eliminate the middle man and get closer to the end customer. In these situations, a manufacturer normally acquires or integrates with wholesalers or distributors to control the direct sales to consumers. If, for example, the tire manufacturer wanted to increase B2B sales by selling directly to auto dealerships, it could acquire or merge with the logistics company that supplies auto dealers with the manufacturer's tires. This type of integration also reduces costs and increases profitability.

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